The market for synthetic investment and risk management products (financial derivatives) has grown in less than three decades from zero to notional values that sometimes exceed the value of the underlying assets. The size of the worldwide swaps market alone is estimated to exceed $40 trillion today.
The growth in the market for synthetic investment and risk management products has occurred because very large financial institutions and corporations have been able to use synthetic products to produce superior investment and risk management performance relative to the underlying assets. However, effective use of synthetic investment and risk management products has been largely restricted to very large financial institutions and corporations because of the large contract sizes typical of synthetic products and the degree of sophistication required for their effective use.
Opening the market for synthetic investment and risk management products to a broader market of medium and smaller-sized investors and businesses requires the creation of efficient, computer-managed funds for investment and risk management products. There have been a very few articles in professional journals (Herbst, Anthony F., and N. Ordway, “Stock Index Futures and the Separability of Returns,” The Journal of Futures Markets, Vol. 4, No. 1, Spring 1984, pp. 87-102; Hill, Joanne, and Humza Naviwala, “and Enhanced Index Strategies Using Futures on U.S. Indexes,” Journal of Portfolio Management, 25th Anniversary Issue, 1999, pp. 61-74; Miller, Todd, and Timothy Meckel, “Index Funds with Derivatives,” Journal of Portfolio Management, 25th Anniversary Issue, 1999, pp. 75-87) that have addressed the creation of superior investment performance using synthetic products, but none have considered the issues involved in creating efficient, computer-managed funds for synthetic investment and risk management products that will make these products available to a broader market.
The benchmark for investment performance is market investment performance, measured by an index of market performance such as the S&P 500, the Russell 2000 or the Wilshire 5000.
Stock index funds were developed in order to offer investors the choice of matching market performance as closely as possible. However, even the most efficient stock index funds face transactions costs, management costs and tracking errors that prevent them from actually delivering performance that matches their chosen market index.
Present stock index funds suffer from significant transactions costs because of their need to constantly adjust their holdings of a large number of stocks in order to maintain a portfolio that accurately reflects the performance of the stock index that the fund managers are attempting replicate with their investment fund. In an attempt to reduce these costs, fund managers have developed “tracking portfolios” that contain fewer stocks than the index but have, in the past, tracked the performance of the desired index within certain margins.
The use of tracking portfolios reduces the number of stocks that must be traded, thus reducing transactions costs. However, differences between the tracking portfolio and the specified index may cause the performance of the index fund to deviate somewhat from the index that the fund is seeking to track and the past performance of tracking portfolio relative to the index does not guarantee its future performance. Also, the tracking portfolios still contain large numbers of stocks (although significantly less than the number of stocks in the index) and, as a result, transactions costs remain significant.
The transactions costs significantly increase when a stock index fund is attempting to track an international index or indexes. Foreign stock markets are less liquid and have higher transaction costs relative to U.S. markets. In addition, many foreign governments add significantly to the costs of index funds holding their stocks by imposing transfer taxes and/or dividend withholding taxes on foreign holders of their equities. This is a growing problem for stock index funds as more and more investors realize that global market performance is the true investment benchmark in our global economy.
Stock index funds face a significant management, cost and risk problem when, as often occurs, a stock is removed from the market index being tracked and is replaced by a new stock. In order to track the index, stock index fund managers must all sell the stock leaving the index and buy the stock entering the index at approximately the time that change in the index occurs. Because traders and other investors know which stock the index fund managers must sell and which they must buy and when, it is difficult for the index fund managers to execute the trades without receiving an abnormally low price for the stock being sold and paying an abnormally high price for the stock being purchased, thus negatively impacting their investment performance.
Another problem with present index funds, for taxable investors, is the creation of unrealized capital gains that may build up in large amounts before being realized as a result of the transactions required to track the index. Investors in the fund do not know the amount or the timing of the capital gains that may result from the realization of these embedded capital gains as a result of the transactions necessary to track the index. Changes in the makeup of the index (e.g., as a result of merger activity) and/or changes in relative prices of stocks within the index may trigger the realization of large amounts of embedded gains.
In addition to making tax planning difficult for taxable investors, the realization of these embedded gains can create tax liabilities for gains that actually occurred before the investor purchased the fund, thus causing the investor to owe tax on gains that the investor earned. The investor ends up owing tax on “phantom” gains because the investor paid a price for the shares of the fund that included the embedded gains that were realized and, therefore, now owes taxes on gains that the investor never received.
The emergence of deep, liquid markets for futures and options on popular stock indexes has made it possible to use synthetic investment products to overcome the problems of high transactions costs (especially for foreign equities), the imperfections of tracking portfolios, the uncertain timing of taxable capital gains and the problem “phantom” capital gains and create enhancements that can enable investors to actually outperform market indexes on a regular basis. One of the inventors of the present invention, Anthony F. Herbst, has published academic research (Herbst, Anthony F., and N. Ordway, “Index Futures and the Separability of Returns,” The Journal of Futures Markets, Vol. 4, No. 1, Spring 1984, pp. 87-102) on the use of stock index futures to obtain superior investment performance. This research (and the other published research on using synthetic products to create superior investment performance) does not consider the creation of synthetic index funds that can bring this superior investment performance to a broad range of investors.
Reduced transactions costs translate into improved investment performance for the investor, especially investors pursuing active trading strategies. Increased accuracy in tracking the market index benefits the investor. Eliminating taxes on “phantom” capital gains benefits investors, especially investors pursuing active trading strategies. Enhancements that create above-market return benefit investors by providing superior investment performance. The creation of a computerized process for managing synthetic investment and risk management funds makes it possible to create synthetic funds that make these benefits available to the broad spectrum of investors rather than just the elite few.
One way to enhance a synthetic index fund in order to produce investment performance superior to the market index is to manage the portfolio of interest-bearing assets so as to produce interest income exceeding the Treasury Bill rate. In market equilibrium, the difference between the price of the index future and the price of the underlying stocks is a function of the difference between the interest income on an amount of Treasury Bills equal to the amount of the underlying stocks and the dividend income on the underlying stocks. Since only a small amount of the interest-bearing assets must be held in Treasury Bills, it is possible to earn enough extra interest income to enable the synthetic fund to outperform the market index.
In addition to improved investment performance relative to present index funds and even the market index itself, a computer-managed synthetic index fund can offer investors options that are not available with present stock index funds. The options which might be offered to an investor, all of which could be efficiently offered by a single synthetic fund, include: 1) the choice of multiple kinds of interests involving different derivative instruments and/or different interest-bearing assets, including foreign derivatives and/or interest bearing assets; 2) the choice of different classes of interests offering varying degrees of leverage for the derivative instruments; 3) the option of different classes of interests that include short as well as long derivative positions; 4) the ability to trade interests quickly and at low cost throughout the trading day; 5) the option to switch among various classes of interests quickly and at a low cost; 6) the option of the investor custom creating his or her own class of interest and varying the nature of this custom interest over time; and, 7) the option to invest in one or more classes of interests managed by professional managers.
Many of the benefits that can be created by computer-managed synthetic index funds are of special value to investors (and investment managers) whose investment strategy requires active trading. Active trading magnifies the transactions cost advantages of a computer-managed synthetic index fund and the tax treatment of futures and options (all gains are taxed 60% long-term and 40% short-term) can create significant tax savings for active traders. In addition, computer-managed synthetic index funds can offer investors limit orders and the ability to trade at any time during the day—neither of which are possible when investors trade shares in conventional stock index funds.
Synthetic products are also widely used by large financial institutions and businesses to manage risk—especially interest rate risk and currency risk. The computer process that is the subject of this invention can also be used to manage synthetic risk management funds that will broaden the market for managing interest rate and currency risk to include smaller and medium-sized businesses and institutions.